McKinsey PST essential business knowledge February 16 2015
The McKinsey PST doesn’t test your business knowledge per se. It tests your ability to think analytically under time pressure. Having said that, the PST is based on real business cases and being comfortable with basic business terminology makes a big difference.
We have put together a short list of essential business terms and a few tricks that will help you answer business-related questions. Remember: the key to being successful at the PST is enough preparation to walk in and solve the test without stressing out. Knowing the terms below is part of this preparation.
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To understand businesses, you have to know how their performance is measured. Below are three key accounting terms that you need to know.
1. Revenues: Revenues, sales, or turnover (the three terms are synonyms) are the total amount of money that the company receives from customers by selling its products.
Let’s take an example. Imagine you work for an airline, such as easyAirways in our free McKinsey PST, or British Airways in real life. You sell plane tickets to your customers. The total amount of money you collect from customers in exchange for plane tickets (and any additional services you provide) is your company’s revenues.
There are two main ways you could be asked to calculate revenues for a company:
You might be given the number of products the company sold (the volume) and the average price of the products. From this, you can obtain revenues using the following formula: Revenues = Volume x Average Price.
Alternatively, you could be given the total sales in an industry (total market sales), and the share of the industry’s revenues represented by the company (the market share). The company’s sales would then be given by: Revenues = Total Market Sales x Market Share.
Either way, remember that revenues or sales are measured in terms of money (Dollar, Pound Sterling, Euro, etc.).
2. Costs: Costs, or expenses, are the total amount of money that the company pays to its various suppliers. In the case of the airline above, this will be the money that the company pays for fuel, leasing airplanes, the salaries of the crew, as well as expenses such as the cost of running their headquarters, their website, or even taxes and interest on loans.
As you can see, the term ‘costs’ covers many different items. Companies will be interested in tracking costs closely.
Fixed and variable costs: Businesses incur two types of costs. Variable costs are the costs that increase with higher sales or higher production. Fixed costs are the costs that would have to be paid regardless of how much is produced. In other words, variable costs change with the level of business activity, while fixed costs don’t.
Let’s imagine you are the CEO of a handbag manufacturer. The cost of the material you use to manufacture the bags is a variable cost: the more bags you produce, the more leather you will need. If one day you produce no handbag, then you don’t have to pay for any extra material. By contrast, the rent you pay for the store has to be paid every month, regardless of whether you sell or produce any bags that month.
As you may already appreciate, the distinction between fixed and variable costs is not always straightforward. For instance, labour costs can be either fixed or variable. As a CEO, your salary is a fixed cost as it will be paid independently of how many bags the company produces. However, during periods of peak production you might hire extra workers at your factory and their salary will therefore be a variable cost.
Even though these difficulties might arise, PST questions will always allow you to determine easily from the context which cost is fixed and which is variable.
3. Profits: The most important relationship in business analysis is probably the following:
Profits = Revenues – Costs
Profits, also known as net income or net earnings, represents the money left to the owners or managers of the business after all expenses have been paid. Many questions in the McKinsey PST and in case interviews revolve around whether or not a company is profitable and what it should do to become more profitable.
Profits are always calculated over a certain period of time – either a quarter or a full year. If you are given fixed and variable costs, you would first have to calculate total costs over the period of time studied, before being able to calculate profits. For instance, in our handbag manufacturing example you would take all fixed costs for one year and add all variable costs for the production of that year to calculate total costs. Annual profits would then be given by subtracting total costs from annual revenues.
Given this definition of profits, there are two ways companies can increase their profits: increase revenues, or decrease costs. You can also see why it might not always be completely straightforward to compare the performance of two companies: one might have higher revenues but higher costs than the other. We will see below how to address this issue.
Knowing the three terms above is essential to attempt any business related test or interview. One of the difficulties associated with learning business vocabulary is that these terms often have many synonyms. There are also closely related terms that are not synonyms and that you might encounter. We list those below.
1. Gross revenues vs. net revenues: Sometimes you will be told that a company earned a certain amount of gross revenues or net revenues. This might be because a company provides discounts to its customers. In this case, gross revenues will be recorded as the money that the company would have received if it had charged the full price to its customers, while net revenues are the amount of money that the company actually did receive.
Another example is when companies have to deal with goods returned by customers. Apparel retailers often face this situation. The gross sales will then be the total amount of money received by the company from selling its merchandise, while net sales will subtract the value of any goods returned by customers and reimbursed by the company.
Note that the distinction may arise in other contexts as well.
You should be aware of this distinction. The smallest number, net revenues, is usually the one that matters. It is the one that will be used to calculate profits, since money returned to customers through discounts or reimbursements will not go to the owners of the company.
2. Cost Of Goods Sold (COGS): As mentioned above, costs come in many different forms. A key component of costs is Cost Of Goods Sold, also known as Cost of Sales. COGS represent the total amount of cost that the company can attribute to a particular item they sell.
Let’s return to our handbag-manufacturing example. For each handbag you sell, you have to buy leather, pay an employee to assemble the handbag, and face some costs to transport and store the good until it is sold. All of those expenses count towards the handbag’s COGS. This is because they can all be traced back to one single item.
The opposite of COGS are called overheads. These are costs that cannot be allocated to any particular good sold. In the example above, the costs of a marketing campaign, the costs of employees operating the store or your salary as a CEO cannot be attributed to one particular good and therefore do not fall under COGS.At this point, the distinction between variable / fixed costs and COGS / overheads may not seem obvious. You may be tempted to think that if all COGS can be traced back to the production of a particular item, then they will change with production, and COGS and variable costs would be the same thing. However, COGS and variables costs are distinct. In particular, some COGS may be variable and others fixed. For instance, the storage of goods is generally included in COGS, even though it is independent of production if your company rents the storage facility on a long-term basis, and therefore a fixed cost.
3. Gross profits are calculated as Revenues – COGS: they represent the profits of the company before subtracting overheads.
Ratios and metrics
1. Growth rates: Many McKinsey PST questions will require you to calculate or compare growth rates. Growth rates are a very useful basic tool for businesses as they allow managers to determine whether the company is going in the right direction, and how its performance compares with previous years. Growth rates can be calculated for any of the performance measures we defined above: sales, costs or profits. For example you could calculate the growth in revenue between 2014 and 2015 using the following formula:
Revenue growth = (Revenue(2015) – Revenue(2014)) / Revenue(2014)
You might also encounter the acronym CAGR: it stands for compound annual growth rate. Given a starting quantity and a quantity several years later, the CAGR is the rate at which the quantity would have to grow every year from the first period to reach the amount of the last period. This could be different than the actual year-on-year growth, which may not be constant.
For instance, suppose your company generated $100m in revenues in 2013. The next year, revenues grew by 2% to $102m. The following year, your sales grew even faster, by 4%, so that revenues for 2015 stood at $106.1m. The CAGR represents the average annual growth over these two years. However, it will not be equal to the arithmetic average (which here would be equal to (2%+4%)/2=3%), because we need to account for the fact that the 4% growth is based on $102m not $100m (this is the compounding part). The formula for the CAGR is ((sales 2015)/(sales 2013))^(1/2)-1 (the ½ corresponds to raising the ratio to the power 1/(number of years)). This gives 2.995%. As you can see, the arithmetic average is in fact very close to the CAGR. This means that in most cases, when the number of years is small and the growth rate low, you can approximate the CAGR by the average growth rate, instead of using the exact formula.
2. Margins: Another term that you will encounter frequently is margin. Margins are essentially any of the quantities we may be interested in, divided by net revenues. For instance, you can define the profit margin as:
Profit margin = Profits / (Net Revenues)
Equivalently, you could define the gross profit margin as (Gross Profit) / (Net Revenues).
Remember the issue we had with comparing companies based on absolute profit? Profit margins provide a more direct way to compare companies. Since they are always expressed as a percentage, you can say that a company with a higher profit margin is performing better, relative to its size.
In the McKinsey PST, you might be given a profit margin and be asked to calculate sales given profits, or vice versa. Using the definition above will allow you to answer this type of questions.
3. Revenues / profits per product or revenues / profits per employee: While expressing profits as percentages of revenues (margins) is the most common thing business analysts do, you might encounter some quantities expressed in ‘per unit’ or ‘per employee’ terms. These measures can also be useful in assessing whether some product or some group of employees are performing better than others.
These few definitions cover the essential business vocabulary that you should know before taking the PST. Knowing these terms will make you a lot more comfortable going through the business descriptions and the questions in the test. As a result you will increase your speed and your level of confidence on the day of the test. They will also come in handy in a case interview. This list is far from exhaustive however; another way to get acquainted with more business jargon is by reading business books or business news.
If you have any questions on the terms above or on any other term not featured in the list – feel free to share them in the comments section!
List of synonyms:
- Revenue(s), sales, turnover
- Cost(s), expenses
- Profit(s), net income, net earnings
- Gross / net revenues, gross / net sales
- Cost of Goods Sold, Cost of Sales
- Overheads, overhead expenses
- Gross margin is sometimes used as synonym to gross profit, rather than as referring to the ratio of gross profit to net revenues
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